Charles Plosser thinks there’s a ticking time bomb at the Fed

The way Charles Plosser sees it, the Federal Reserve is sitting on a ticking time bomb that could severely damage the economy unless the central bank reacts quickly to defuse the looming threat.

The Philadelphia Fed president, viewed as one of the bank’s leading hawks, is worried about some $2.5 trillion in “excess” reserves. That is, loanable funds available to individual or corporate borrowers through the nation’s banks.

The Fed has created these reserves through unpredented purchases of U.S. Treasurys and mortgage-backed securities, a strategy known as quantatative easing.

These reserves are just sitting in the bank system, basically doing nothing. That’s because demand for loans has been unusually weak amid an economic recovery that’s the slowest on record since the Great Depression.

“These reserves are not inflationary right now,” Plosser said in a meeting Tuesday with reporters in Washington.

Yet if borrowing begins to surge and those reserves start to pour out of the banking system, Plosser worries, “that’s going to put pressure on inflation.” The result: the Fed could be forced to raise interest rates faster and earlier than it would like and perhaps slam the breaks on the economic recovery.

The Fed tried to avoid such a problem in the past simply by not creating so much excess reserves in the first place. If the excess reserves did not exist, banks could not lend out too much money and trigger an inflationary spiral.

What’s different now is the reserves have already been created. So the Fed has to figure out how to withdraw the massive reserves it’s injected into the banking system without causing major economic harm in the process.

“One thing I worry about is that if we are late, in this environment, with all these excess reserves, the consequences might be … more dramatic than in previous times,” Plosser said. That’s central-bank speak for an economic fiasco.

The timing and strategy by which the Fed handles the drawdown in reserves could end up a major source of contention among central bank hawks and doves. “Our challenge is subtly different,” Plosser said. “We have to restrain the pace at which banks lend those reserves out.”

Go too fast and economic growth could get stunted. Go too slow and inflationary pressures would build rapidly. In the past, Plosser asserted, the Fed has almost always reacted too late. “If you study the Fed over the years, over its history, its always behind the curve.”

By the time the Fed ends it bond-buying campaign – mostly likely in the fall – the central bank’s total balance sheet could reach a record $4.5 trillion.

Yet other top officials, such as New York Fed President William Dudley, argue that withdrawing reserves too quickly is probably a bigger danger than reducing them too slowly as Plosser fears given the weakness of the U.S. recovery. Read: Fed’s Dudley says pace of rate hikes to be ‘slow.”